Messy Initial Results Should Not Obscure The Long-Term Value At First Horizon
First Horizon had a strong core earnings result in the third quarter, with double-digit outperformance on pre-provision profits and lower provisioning, but NIM and expense guidance were soft.
The Street may have been too hasty in the negative reaction to guidance, as management is only just beginning to optimize Iberiabank's deposit and cost base, and lending is healthy.
Management has to show improved credit quality over the last cycle, as well as improved profitability, to get a better valuation, and both will take time to establish.
I continue to believe that First Horizon is materially undervalued at today's price.
Investors like clean beat-and-raise quarters, and they didn’t get that from First Horizon (FHN) this quarter. The first couple of quarters after large mergers are often messy, so no real surprise there, but the underlying guidance for weaker core net interest margin wasn’t welcome in a quarter where “stabilization” has been the overall theme. Likewise, First Horizon’s credit quality remains a negative talking point and the core profitability is still not impressive.
None of this should really be a surprise, but the Street wants what it wants, and stocks get sold off when it doesn’t get it. On a core basis, nothing has changed for me with respect to modeling, my bullish drivers, or my bearish concerns. First Horizon management has a lot to prove – they have to prove they’ve learned their lessons on credit/underwriting quality and they must prove that this newly-enlarged bank can be more than a middle-of-the-road performer where profitability is concerned. My position is that they will prove this over time, and that the shares can deliver a mid-teens annualized return from here, but investors are going to have to be patient with this one.
Messy Results, But A Solid Core Performance
Talking about year-over-year or quarter-over-quarter growth for First Horizon is pretty much pointless this time around due to the acquisition of Iberiabank. Even still, it’s worthwhile to compare First Horizon’s core results to the sell-side’s expectations. While there were a couple areas that I’ll flag as concerns (core spread and credit), all in all it was a decent-to-good quarter in my view.
Before getting into the numbers, I want to again note that different analysts make different adjustments to arrive at “core” numbers, so your mileage may vary. Likewise, you can’t always know what assumptions go into reported “consensus” numbers, so that’s a potential source of some variance.
Revenue was about 3% above expectations, with net interest income a little more than 1% better than expected. While earning asset growth and net interest margin were both better than expected (NIM beats haven’t been all that common), core net interest income was weaker than expected. Here you have one of the paradoxes of the banking sector – analysts and investors will often cheer bank deals when they’re announced due to the expected purchase accounting accretion, but then they strip it out of results later on. Core results do matter, and underlying performance was disappointing (I’ll address that later), but I wouldn’t have sold the shares just for that reason.
One of the things I liked about First Horizon going into this downturn was the company’s leverage to non-spread sources of revenue like capital markets (bond trading for clients) and mortgage banking. Core non-spread income did beat by a little more than 6%, but that’s actually a little disappointing to me in a quarter where many banks posted significant double-digit beats.
Core expenses were a little better than expected, and the core efficiency ratio was more than three points lower than expected, fitting a larger trend of good opex control. Core pre-provision profits came in 12% ahead of sell-side expectations, which was very much in line with the beats I’ve seen from good banks this quarter. One area where I will ding the company is overall profitably with a core PPOP/avg. loan ratio of 2.3%, First Horizon’s profitability is pretty mediocre.
Mixed Trends On Credit
Credit wasn’t such a solid area for First Horizon, and this is an area I flagged before as a possible source of risk due to past issues with First Horizon’s underwriting quality, Iberia’s significant energy book, and what I saw as a too-low level of reserves for Iberia’s book earlier this year.
Provisioning expense was well below expectation, another theme across the sector, but the charge-off ratio jumped from 0.20% in the second quarter to 0.44%. That was a worse result than expected, but not really much worse than the sector as a whole, with banks like Regions (RF) and Truist (TFC) basically in the same neighborhood (and others like Citizens (CFG) and U.S. Bancorp (USB) above that level). Most of the charge-offs came from the energy book, which really isn’t too surprising.
Deferrals declined from over 13% to 2.4% exiting the third quarter, and that’s not really out of line. I’d also note that the non-performing asset ratio was stable, while non-performing loans declined modestly from the second quarter. I’d have liked more information on criticized loan evolution, but that will wait for the 10-Q.
Exiting the quarter, First horizon had a 1.65% loan reserve ratio (1.80% allowance for credit losses), and an adjusted ACL of 2.15% excluding PPP loans and mortgage warehousing loans. Add in the loan marks from the Iberia deal (which is effectively another layer of reserves) and I’m not really concerned about First Horizon’s reserves. What really remains to be seen is how many C&I and CRE loans go bad, as First Horizon still has very high exposure to industries at risk from COVID-19 – management’s estimate of 10.8% is too low in my view, as it excludes areas like healthcare that I believe will still see some elevated losses versus historical experience.
Near-Term Pressures, Longer-Term Opportunities
Maybe the worst development coming out of the quarter was management’s guidance for weaker NIM (down high single-digit to low double-digits) at time when other banks are reporting stabilization. Management also guided to seasonally softer results in trading and mortgage banking, and somewhat higher expenses.
I believe these are timing issues to at least some extent. First Horizon is getting hit by excess liquidity, but loan demand seems healthy (loan balances were more than 2% higher than expected), and loan demand could surprise from here. Moreover, management hasn’t even started optimizing the Iberiabank funding base (running off higher-cost deposits, et al), and that should drive better NIMs in 2021 relative to Q4’20. Likewise with expenses – First Horizon is only just get started with the integration of Iberia, and I have to imagine that COVID-19 has created a few unexpected challenges there.
The Outlook
The outperformance of the third quarter outweighs the weaker guidance for Q4, so my 2020 core earnings expectations are now higher. I haven’t really changed the estimates much beyond that, though, as I want to see how the company performs with respect to deposit costs, credit losses, merger synergies, and so on. All in all, I’m still looking for core earnings growth in the mid-single-digits on a long-term annualized basis over the next decade.
The Bottom Line
These shares have outperformed the peer group since my last update, but First Horizon continues to look undervalued on the basis of both near-term ROTCE and long-term core earnings; moreso on the latter than the former as the benefits from the Iberia deal won’t come just over the next 12-18 months. While near-term guidance was disappointing, I think the core performance was still no worse than okay, and I believe there are still meaningful synergies to be had from the Iberia deal. I see elevated risks here (credit, etc.), but I do use a higher discount rate and I believe the shares are still meaningfully undervalued on a risk-adjusted basis.
Disclosure: I am/we are long TFC, FHN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
